Tag Archives: globalization

Crisis of Confidence

I, through my firm, was a customer of PFG, the latest registered broker dealer to steal from its clients’ accounts – first reports indicate $200 million may have been taken.  This pattern is becoming too frequent. Innocent victims have lost money yet again.  How did it come to this?

Broken Markets

Self-regulation by an oligopoly… I don’t think there is any economist or politician who wanted this outcome, but special interests and lobbying have led to this.  This is how the futures industry works today.

Capitalism is broken without fair rule of law and regulation, and today top firms organize and self-regulate with practices that add cost but lack teeth. This discourages competition from smaller companies, but it also gives the largest companies free reign to raid their clients’ accounts and hide their crimes for years. So far it seems there is little or no accountability when they are discovered.

If market participants cannot expect basic protections, then they will leave, prices will fall, volume will shrink, and markets will whither.  Companies will have less access to capital and be exposed to more risk, and the economy and workers will suffer.  We’re already a long way down this path.

The economic ideal and the allure of free markets is only possible when regulation protects innocent market participants, minimizes fraud and cheating, and does not deter innovation. That means expanded domain of the SIPC, the SEC should have unlimited authority to monitor accounts and communication (opt-in would be fine), and companies should only minimally participate in their own oversight. With this structure, investors would be protected, transparency would reduce fraud, and free markets could flourish with competition and innovation.

Sounds obvious, but don’t hold your breath.

Corporate Corruption

There are a lot of types of corporate corruption, but they all start from an imbalance in power and oversight.  There is one tiny change could have a huge impact on this problem: allow shareholders to nominate people for elections of the Board of Directors of public companies.  It’s a small, seemingly obvious shareholder right, but it would have a big impact.

Management should not have the exclusive right to nominate their bosses. In fact, because the Board of Directors is supposed to represent the owners’ interest, it seems crazy that owners can not nominate. When the owners of a company are empowered to nominate Board members, management comes back under control, compensation comes back to reality, performance is scrutinized better, and the interests of investors are better served.

In private equity and smaller firms of every kind, this is always how it has worked.  Major shareholders often join Boards of private companies and nominate other Board members.  How public companies ever achieved the ability to control the Board nominations without rights for shareholders, I’ll never understand.

Too much

There are so many other ways that markets are broken and corruption is bringing us down.  Is it too much to fix?  Are we destined to watch for the rest of our lives as the emerging markets grow right past us and Americans fight amongst ourselves? Is our political and influence machinery too dogmatic or corrupt to embrace new good ideas together?

I’m not confident.

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The Independent Globalist: an instruction manual

I drink your milkshake

You drank my milkshake!

Independent globalists optimize after-tax returns, labor, and supply chains into the tax and regulatory regimes that are most favorable.

It’s an optimization exercise and a chess game.  This seems to be the dominant strategy:

1) After-Tax Returns

The equation: taxes + regulation.   Taxes are simple; they reduce your profits by their rate.  Regulation is more complicated because it costs money to comply, but there are also opportunity costs from business activities that are no longer available.

The game: reduce and eliminate taxes and regulation.  Express the stresses of international competition to pressure national politics using one issue at a time in the countries where you do business.

2) Labor

The equation: salary + benefits, including long term commitments.  Retirement, health care, and other benefits have costs, but also may reduce employee turnover.

The game: reduce and eliminate costs within each role.  Divide operational units and move them to locations with optimal rules and costs.  Use the placement of these units to pressure politics to reduce labor’s collective bargaining rights.

3) Supply Chains

The equation: price.  Commodities and other non-labor costs are priced on global markets, and are mostly fungible.

The game: reduce and eliminate regulations that internalize costs of production for your suppliers.

Investors lost $2.5 Trillion on Monday – Policy?

Investors lost $2.5 Trillion on Monday because stock markets were down.  Who still thinks stimulus is a bad idea?  How can anyone argue that it is a bad investment to spend a few hundred billion in the form of infrastructure or other stimulus when the effects are 1000%+ in the form of rising market valuations across the economy.  Stock prices rise in value within minutes when stimulus is announced.  American Freedom does not eliminate our right to make great investments for our economy.

Policy makers – and the rest of us – should pay more attention to ROI.

Planning and Investing for the Long Term

2 Great articles quickly tell the story of global trends, risks, and strategies:

The 1st, by McKinsey & Company, focuses on Globalization’s critical imbalances:

Globalization’s critical imbalances

The 2nd, by Investors Insight, talks about how to use global macroeconomic issues like these in your investment decisions:
What’s the point of macro?

Failure, Contagion, Panic, … and the Future

The original article is available in PDF format here: Failure, Contagion, Panic, … and the Future


Failure

“This is a once in a half century, probably once in a century type of event”
– Alan Greenspan, September 15, 2008

Failures of judgment appear to have been epidemic in the US economy. A brief summary of major failures includes:

  • Insufficient regulation of banking system leverage,
  • Lack of regulation in mortgage origination,
  • Low interest rates and too much borrowing
  • Indiscriminate purchase and bundling of imprudent mortgages,
  • Public mania in real estate,
  • Insufficient enforcement of existing securities regulation
  • Institutional competition toward unlimited investment leverage,
  • Accounting rules that unfairly punish illiquid securities,
  • Concentration of credit risk within AIG,
  • No prepared means to resolve a breakdown in interbank lending.

These failures revealed themselves like layers in an onion as credit became unavailable and investors sold into falling prices.


Contagion

Bad mortgages are generally blamed for causing this crisis, but they were just the trigger. Think of them as the match that lit the bomb that caused the crash. Fundamentally reasonable declines in mortgage securities were magnified many times by fundamentally unreasonable leverage in the banking system. These magnified losses drove a small number of financial institutions toward insolvency, so they were forced to unwind their investments. The contagion had begun.

Selling became a race because as selling drove down prices, overleveraged institutional investors lost their collateral to support their portfolios. So selling begat selling. Because falling prices and a lack of buyers drove companies like Bear Stearns, Merrill Lynch, and Lehman Brothers into collapse, a new kind of risk was exposed: counterparty risk.

Counterparty risk is generally ignored in securities valuation, but if the party that owes you money (or oil, or stocks) fails, then counterparty risk becomes important. People stopped trusting their counterparties so lending and trading between banks slowed way down. Some markets had “no bid” and stopped trading entirely.

When your investments have lost money and you are forced to reduce your leverage, you hope for a liquid market with ample buyers. But with counterparty risk seizing the markets, there were only vultures to be found.

Panic

Large institutional investors could not sell because trading had seized. The few transactions that occurred were at desperation prices. Meanwhile, new laws requiring institutions to quote their assets using “mark to market,” as if all similar securities should be priced like the few transactions taking place, added further chaos. The paper losses from a small number of desperate sales multiplied against the entire asset base of the banks. On paper, many banks instantly became insolvent. Counterparty risk suddenly became the priority and credit markets failed to operate. Prices plunged, fear spread to the public, and mutual fund redemptions jumped to $75 billion in September (3 times the previous record set in 2001).

All manias and all crashes are, at their core, psychological. But psychology is very real, and in crowds it drives society and the economy. Free markets are subject to free fall when everyone wants to sell and there is nobody willing to buy.

With a somewhat dispassionate perspective, it’s curious to watch the public enthusiastically follow momentum: euphorically buying high and fearfully selling low.

The Future

The Valuable US Dollar

The collapse of the credit system is (or was) highly deflationary. As the volume of credit declines, so does the money supply, and with less money each dollar is worth more. That is why commodity prices fell in half, stocks crashed, and home prices declined. On the flip side of the coin, the recovery of the credit system is (or will be) highly inflationary. In addition to recovering toward the reasonable availability of credit, the government has also pumped a lot of new money into the system. While the short-term may be deflationary, the longer-term appears to hold significant risk of a US dollar that is declining in value.

Leverage in the banking system directly reflects the debt of companies and of people. Debt is one side of the leverage ratio, with reserves on the other side. As leverage is brought down to more reasonable levels, the overall level of debt must, by definition, be reduced. That means that corporations and people must pay down debts in order to deleverage the banking system. If leverage ratios are cut from 20x to 10x, then we must all (on average) pay off half of our debts. This will have a depressive impact on consumer spending and economic growth and could lead to big problems if it is done too quickly.

Many companies finance their operations using debt, and many will fail. Profitable companies often finance their growth using debt, using their operating profits to pay bigger salaries and bonuses and if this debt is cut in half then there will be less investment to grow companies, and less money for salaries and bonuses. People who are in debt will have to consume much less because consumer credit could be cut in half. Dollars become scarce and the value of the dollar goes up. In summary: deflation and depression. The government is going to great lengths to avoid this!

“There are risks and costs to a program of action. But they are far less
than the long-range risks and costs of comfortable inaction.”
– John F. Kennedy (1917 – 1963)

1. Bailout – Government can provide banks with additional reserves.

If the Federal Reserve or the Treasury buys debt or equity in banks, it can have the proceeds used as reserves and go directly into the Federal Reserve as “high powered money”. This would reduce the leverage of the banks and allow them to continue operating as usual. Because of the reserve ratio, every dollar invested into a bank’s reserves has many times as much impact on credit and the money supply. If the reserve ratio is 9:1, for example, then, because of interbank lending, the impact on credit and the money supply can be as much as 99 times. That is why it is called high power money, and this would be a very potent way to fix the credit markets in the short term. In the long term, the banks would have lost some of their own equity, and would work to avoid such a loss in the future.

The downside of this form of bailout is that the government would own part of the banking system, spend taxpayer money to do it, increase the money supply, increase debt, and not do anything to fix the structural problems that led to so much leverage.

2. Regulatory Overhaul – Government can change the system to engineer a soft landing.

New regulation of reserve ratios, credit, and securities markets are probably required to reduce the chances of systemic failure in the future. We think there should be a target reserve ratio just as there is a target fed funds rate. Credit regulation should include minimum collateral limits for derivative securities such as mortgage backed securities, credit default swaps, and other derivatives linked to a credit spread. Securities brokers would be responsible for reporting aggregated (clients remain anonymous) positions and collateral by security type.

The dollar has been strengthening lately as an anomaly within a long downtrend. This is no coincidence: the strength of the dollar reflects big investors reducing their leverage, repatriating US cash, selling down leveraged international investments, and generally holding more cash. As banks reduce their leverage, the money supply shrinks, so each dollar is worth more. The dollar was falling in value for years as leverage increased (money supply increased) and now, very quickly, the opposite has happened.

“Decoupling”

We have heard the argument that decoupling is dead: that international trade has brought every market into shared economic cycles. We don’t see it as a question of “either/or”, but rather as a continuum. Global growth is diverse and strong. There are certainly correlations caused by shared trends (such as trade, technology, cultures, etc.) and shared sources of capital, but these have been exaggerated in the past few years by excessive leverage that has given excessive influence to global institutional investors.

As the world economies emerge from the current financial crisis, expect lower correlations. In other words, expect some countries to emerge very strong and others to remain depressed for much longer. Countries with healthy political and economic foundations, along with abundant natural resources, are in the best positions. Brazil, Canada, India, Mexico, and China may be very strong.

The Fundamentals of the World Economy are Better than you might Expect

This is true whether you are talking about the American workforce or global economic statistics: the fundamentals are generally fine. Some of the statistics are clearly not strong but the overall picture is far from a disaster.

Gross World Product (GWP) growth has slowed from a 5% rate in mid-2007 to an estimated 3.7% in 2Q 2008, with 3% growth projected for the second half of this year. International liquidity growth slowed from 12% to 1.6% and global capital investment growth slowed from 6.5% to 3% over the same period. GWP, liquidity, and capital investment are all still growing. Liquidity growth has slowed from an unsustainable pace (more than double the growth rate of GWP), but it is still growing. This is far from a global contraction, and growth is more globally diverse and inclusive than in any previous time in economic history.

World trade volume growth has also been slowing significantly, declining from 9.3% in 2006 to 7.1% in 2007. This year, world trade volume growth has slowed to zero in May/June according to the latest official data. This is not world production, but world trade. World trade puts downward pressure on prices so a slowdown in World trade is inflationary.

Global inflation (CPI) rose from 2.2% in mid-2007 to 7.8% in 2Q 2008. Headline inflation in the industrial economies has risen from 1.4% to 4.2% in the past year, and is at double-digit levels in many emerging markets, the Middle East, South Asia, and Africa.

Global industrial output growth has slowed from 4.4% in mid-2007 to 1.6% in 2Q 2008. In the OECD, which accounts for 73% of world production, output growth has slowed from 3.4% to 0.7% in this period. In non-OECD, industrial output growth has slowed from 8.4% to 4.7%. The OECD represents a shrinking proportion of a growing global demand for resources for industrial output.

In the U.S, Q2 U.S. real GDP grew at 3.3% up from the 0.3% average growth of the prior two quarters.

GDP growth came mostly from export growth. Consumer confidence is at 30-year lows. Disposable personal income in the US rose $596 billion in May from the Economic Stimulus Plan, and consumers saved 84% of that. July data on consumer spending and personal incomes showed contractions in both areas. US Consumers are building up cash and righting their financial positions.

How you Invest

First things first: pay down debts or be ready to do so. We’ve been calling for readers to lock in interest rates on mortgages since July ’06. Credit may be more expensive and more difficult to obtain in the next few years. Companies that rely on credit to finance continuing operations will suffer.

Don’t let fear control you. Buy low. The dollar is strong and securities are cheap. Hoarding cash at a time like this is folly. Invest and diversify into Assets, Commodities, and International Equities. Companies that have international demand or that earn foreign profits may be particularly undervalued. Missing even a few days or weeks of equity or commodity price recovery might mean missing 20% or more in returns. Maintaining your strategic asset allocation balance is more important now than ever, and the dramatic volatility means rebalancing often.

Divest of long term US Treasuries, fixed income securities, and companies that require debt financing to survive. Investments that pay you back as a fixed number of future US Dollars may be eroded by inflation. In the short term, credit markets are essentially seized. In the longer run, it may be decades before debt financing becomes this easy again.

We are in the midst of major global shifts toward free societies, fair markets, growing consumption, and the magnetic attraction of purchasing-price-parity. The biggest drivers of global growth are unshaken:

  1. Expanding production into international (including developing) markets,
  2. Rapid global sharing of social systems and technologies that improve production,
  3. Expanding global trade in both goods and services,
  4. Improving alignment of tax codes and central banking policy in line with global best-practices,

Global investing appears fundamentally very strong, probably more so than at any other time in human history. The current financial crisis should be seen as an opportunity to use strong dollars to buy global investments.

Good luck,

Dan Von Kohorn

The Credit Crunch and the Market

[Download the complete article in PDF format, with charts and better formatting]

The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.

Contagion

The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a “contagion”.

The “Greenspan put” was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the “animal spirits” of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

  • Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
  • A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

Out of Favor, Into the Portfolio

[Download this article in PDF format, with charts and better formatting]

The Dow Jones Industrial Average is hitting new all-time highs while crude oil is making new lows for the year. Moving in opposite directions is normal for these markets, but recent movements may come as somewhat of a surprise against a backdrop in which core inflation has risen to levels not seen in a decade and the yield curve is inverted.

China and India seem to be in a race to secure energy reserves in anticipation that within three years, Asia’s oil consumption will surpass North America’s. Global economic production is expanding by about 4%, about double the average rate of the last 50 years. Growth rates are highest in the countries with the largest populations, and consumption is being subsidized by growing global debt markets.

Stock valuations anticipate strong growth while commodity prices anticipate adequate supplies. This is an intellectual error.

Only fools and economists believe in infinitely compounding growth

For major world markets to continue recent growth rates, many major supply-related hurdles would have to be overcome. Current capacity for energy supplies are insufficient to support more than a few years of continued growth at this rate; additional capacity will have to be created. However, whether or not one believes in the “peak oil” theory or not, it is indisputable that known oil reserves are shrinking while discoveries are taking longer and yielding less.

While the pendulum of stocks and commodities has swung toward stocks, the fundamentals seem set up to push the pendulum back the other way.

Stocks and Commodities; Owning Both

Commodities often move in the opposite direction from stocks over periods of three months or longer. Over longer periods, this negative correlation becomes quite strong; as much as -42% for five-year periods. The result is that these two asset classes have provided strong diversification benefits when combined in a portfolio. Their risks offset each other to a high degree, resulting in more consistent wealth accumulation.

The fundamental basis for this behavior is easy to understand: stocks do well when the resources they need are cheap. Similarly, profits are diminished as the prices of natural resources go up. In addition, as commodity prices rise central banks tend to raise lending rates and slow down corporate growth rates. For this reason, commodity prices tend to be a better hedge against unanticipated inflation than
stocks, and much better than bonds.

Combinations of these two asset classes can be represented along an efficient frontier. This chart makes clear that risk was dramatically reduced by the
introduction of commodity futures while having a very small impact on returns.

Risk-averse investors who are sensitive to maintaining their purchasing power should consider commodity futures as a component of their portfolios.

Ignored Risks

The risk to the value of the U.S. dollar should not be overlooked. Many countries own substantial foreign reserves in U.S. dollar denominated debt. If these countries decided to diversify into a broader basket of currencies or assets, the outflow of capital would put pressure on the value of the U.S dollar. Commodities provide a hedge against volatility in the value of the dollar by maintaining purchasing power.

Global Growth implies Unprecedented Demand

World population is rising at a rate of about 1.3% per annum, or about 10,000 new people every hour. At the same time, productivity in the U.S. is rising at about 2.6% annually. The U.S. has very high productivity relative to other countries, and it is growing. At the same time, the vast majority of the world population lives in countries where productivity is much lower – but catching up.

The process of productivity convergence has been dramatically accelerated by the opening of trade, reforms toward capitalism, and the growth of the internet to share information. The long-term trajectory is for developing countries to grow toward U.S. productivity levels. This simple dynamic has some profound implications: we’re not ready.

If Chinese productivity rises to even half of U.S. levels, that economy’s GDP will expand from less than one fifth that of the U.S. to more than double that of the U.S.

Consider 2 scenarios:

1) An unrealistically pessimistic scenario:

Assumptions:

a. World population suddenly stops growing.

b. The U.S. never innovates, and simply maintains existing productivity levels.

c. Other countries catch up to U.S. productivity levels in 50 years.

Implications:

a. China would average 6.6% growth for 50 years, raising its production by more than 24 times to more than four times the size of the U.S.

b. India would average 8.5% growth for 50 years, raising its production by almost 60 times to more than three times the size of the U.S.

c. Global production would rise by more than 5 times.

2) Constant population and productivity growth:

Assumptions:

a. World population continues to grow at 1.3%.

b. U.S. productivity continues to grow at 2.6%.

c. Other countries catch up to U.S. productivity levels in 50 years.

Implications:

a. China would average 10.8% growth for 50 years, raising its production by more than 169 times, to more than 30 times the current output of the U.S.

b. India would average 12.8% growth for 50 years, raising its production by more than 410 times, to more than 25 times the current output of the U.S.

c. Global production would rise by more than 41 times.

These long-standing and slow-moving global economic trends will almost certainly be interrupted by commodity shortages during this period. Even the most optimistic forecasts for natural resource capacity do not anticipate supporting even the conservative scenario for growth.

Something has got to give.

We expect that as population and productivity trends push demand higher, commodity prices will rise to keep demand lower. Equilibrium prices are likely to be driven increasingly by production capacity as shortages develop. Over time, this will likely slow global growth rates and provide advantages to companies and countries that are net suppliers.